The leading contender to win Japan’s election is Opposition Leader Shinzo Abe, head of the Liberal Democratic Party, a politician who is pledging to throw right-wing financial orthodoxy under the bus to try to revive the economy. (YURIKO NAKAO/REUTERS)

The leading contender to win Japan’s election is Opposition Leader Shinzo Abe, head of the Liberal Democratic Party, a politician who is pledging to throw right-wing financial orthodoxy under the bus to try to revive the economy.(YURIKO NAKAO/REUTERS)

Many investors are focused on the looming U.S. fiscal cliff and asking whether the country’s hitherto crazy politicians will be able to rise to the occasion and craft a deal that avoids plunging the United States into recession.

But there is another political drama unfolding next month with equally weighty implications and money-making possibilities: Japan’s election.

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Economy

The Asian nation has been been mired in a deflationary funk for more than a decade. It boasts the dubious distinction of being home to one of the world’s longest running bear markets, dating from December 1989, which has knocked an astounding 80 per cent off the benchmark Nikkei index.

Over the last decade, the yen has paradoxically strengthened to absurd levels, crushing the competitiveness of the country’s export-oriented industry.

Meanwhile, despite having the scariest government-debt-to-GDP level in the known universe, Japan has pioneered the global trend to ultra-low interest rates. Its 10-year bond yields a microscopic 0.75 per cent – despite the fact that government debt is equivalent to more than double the country’s GDP, a ratio that should give any sensible creditor pause about being an enabler of such profligacy.

What makes Japan interesting from an investor standpoint right now is the possibility that these long-running trends may be about to switch into reverse – which brings us back to the election on Dec. 16. There is a growing likelihood that Japanese voters are going to make their biggest attempt to date to extricate their country from its deflationary predicament. The leading contender to win is Opposition Leader Shinzo Abe, head of the Liberal Democratic Party, a politician who is pledging to throw right-wing financial orthodoxy under the bus to try to revive the economy.

He told the Wall Street Journal last week that he wants to embark on a massive government public works package equal to $2.5-trillion (U.S.) and waive a sales tax increase that was designed to help avoid a credit rating downgrade. He has also criticized the Bank of Japan as being insufficiently resolute in its efforts to increase the money supply and vanquish deflation.

In just the past week and a bit, the prospect of a U-turn under Mr. Abe has lit a fire under the moribund Japanese stock market and knocked the yen down to multimonth lows against the U.S. dollar. Should he win, these new trends could go on for quite some time, enriching the properly positioned investor. The obvious play is to be long stocks, short the yen, and short Japanese government bonds. A Bank of Japan trying to engineer inflation would be expected to drive down the currency. Another massive stimulus program for an already heavily indebted government would be hugely negative for bonds, unless the debt were monetized, in which case the currency would go down even more. But a successful end to deflation would be hugely bullish for Japan’s depressed stock market.

The big question is whether the election will actually mark a turning point. Even the world’s canniest investors are having a difficult time deciding which way to bet, given Japan’s myriad problems.

Earlier this year, Hugh Hendry, the savvy proprietor of London’s Eclectica Asset Management, said in an interview with Barron’s that he figured the yen would strengthen dramatically and many big Japanese companies would be threatened with collapse. He loaded up on credit default swaps, insurance that pays out if companies go insolvent.

Wrong move. With talk of reflation, the value of those swaps has plunged. Mr. Hendry didn’t respond to a request for comment on whether he has exited the positions.

When a trend has gone on for so many years that even some of the most successful contrarians don’t position themselves for it ending, it suggests that maybe, just maybe, this time Japan is truly switching gears.

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